Protons vs. Electrons

My posting last Friday on hydrogen cars for China generated a thought-provoking comment suggesting that advances in battery technology would foreclose the opportunity that hydrogen fuel cells are chasing, at least in automobiles. When you consider developments such as next-generation Lithium-ion batteries that promise to cost less, recharge faster, and last longer than current hybrid car batteries, the threat to fuel cells could be considerable. After all, fuel cells and hydrogen are only one path with the potential to improve vehicle efficiency, reduce oil dependence, and lower greenhouse gas emissions. Hydrogen has no monopoly on these outcomes.

When the first hybrid cars appeared in the late 1990s, they raised the bar against which hydrogen fuel cells would have to compete, in three important areas:

• They provided energy efficiency improvements nearly as large as those promised by fuel cells.
• They reduced greenhouse gas emissions by almost as much as fuel cells, when the emissions associated with producing, storing and transporting hydrogen from natural gas--the primary current source--were included.
• They delivered these benefits at a substantially lower cost than fuel cells, even based on optimistic forecasts of fuel cell manufacturing cost reductions.

The prospect of plug-in hybrids raises the bar even higher, bearing in mind that neither plug hybrids nor fuel cell cars are yet in mass production. Plug-in hybrids would leverage the fuel consumption and emissions of an internal combustion engine by recharging with grid-based electricity, rather than just recycling braking energy, as conventional hybrids such as the Prius do. With improved batteries, the all-electric range of plug hybrids could be significant, and their cost premium over conventional hybrids modest.

As promising as this technology sounds, it's premature to write off the hydrogen fuel cell, because a device with no moving parts ought to have an inherent advantage over even a highly-advanced internal combustion engine. However, better batteries and the rapidly accumulating real-world experience generated by hundreds of thousands of production hybrid cars could keep pushing fuel cells over the horizon for some time.

Deeper Disincentives

Washington, DC, November 10, 2037 - Yesterday's Senate Energy Committee hearing on the exorbitant profits of the biodiesel industry was marked by controversy and a series of heated exchanges between senators and industry executives. Several senators accused the industry of collusion and price-fixing, while the biodiesel CEOs assured the panel that the recent doubling of biodiesel prices--and the resulting earnings bonanza for the industry--was entirely attributable to the summer drought and a persistent blight affecting canola and other oilseed crops. Suggestions that the provisions of the Energy Act of 2022 be waived temporarily to allow diesel cars and buses to fuel up with petroleum diesel brought Senator Jones to her feet. "My constituents have a right to purchase biodiesel at an affordable price, since it is the only environmentally safe fuel for their cars. Your high prices and excessive profits are a betrayal of the public trust granted to you."

This might seem like a highly fanciful scenario, but I think it illustrates an important argument concerning proposed Congressional action to tax the oil industry on its "windfall." As Ben Stein's Sunday NY Times column explained, and as I suggested in last Thursday's posting, this is bad policy with respect to the oil industry, but it also sends worrying signals to the alternative fuels industry that many hope will ultimately supplant a large portion of our currently petroleum dependence.

There is a notion at the heart of the criticism of the oil industry's recent high profits that should make us all nervous, although you'll never see it articulated in precisely this way, that in this country, only the government is entitled to earn more than a few cents per gallon on the sale of motor fuels to the public. Companies in this industry are viewed as performing a public service in a near monopoly, and thus should earn utility-like returns. You'll note that there's nothing in this idea that is specific to oil.

Now, as long as the ire of the public and its elected representatives is focused on oil companies, who deal with unpleasant foreign governments and operate on a scale beyond the comprehension of the average person, this may seem like a reasonable proposition. Fuel for your car is a necessity, not a luxury, after all. Why should someone be allowed to make huge profits at the expense of consumers on products they'd make anyway?

It's even harder to see how this could ever apply to the alternative fuels industry, because at present it is so small--and thus benign. It functions either as a cottage industry or as a semi-philanthropic or highly prospective sideline of big energy firms. But if alternative energy is ever really going to matter, relative to our challenges of energy security, trade imbalances, and climate change, it must eventually operate on a scale comparable to today's oil business. That means producing and selling not just millions, but billions, and ultimately hundreds of billions of gallons per year of fuel.

Now, perhaps the people who currently invest in startup companies in this area would be satisfied merely to break even, because they are motivated by impulses other than the allure of profits. But the alternative fuels industry, whether it is built on biofuels, coal liquefaction, oil shale processing or other technologies, will require enormous capital--probably hundreds of billions of dollars--to attain even a tenth of the scale of the present oil industry. You don't invest that kind of money to earn what you could make on a T-bill or a market index fund. And you won't invest it, if you are convinced that the first time you make a big profit, the government will swoop in and seize part of it, because you are selling the public something they can't do without.

While most of the executives of today's alternative fuels companies would probably think that growing large enough to get on the radar screen of a congressional committee would be a remarkable indication of success, I'd be surprised if the more thoughtful among them aren't squirming already, just a bit, because they recognize the magnitude of the profits they will need to make--in proportion to the tremendous risks they are undertaking--to grow as rapidly as they and we would like.

Hydrogen for China's Cars?

I see in the San Francisco Chronicle that Governor Schwarzenegger included a pitch for renewable energy and hydrogen cars on his recent trade trip to China. He raised some interesting points about energy and the environment, though there are practical limitations on how quickly all this could happen. But as I read this article, it reminded me of the "technology leapfrogging" argument we've frequently heard in information technology and telecoms, and that some have attempted to apply to energy technology. Simply put, could China deploy technologies such as hydrogen fuel cell cars faster than the US, because they are not competing with as much legacy infrastructure? You can't dismiss this argument out of hand.

There are currently at least four major obstacles to the implementation of a hydrogen-based transportation system:

• Hydrogen requires significant energy inputs in its production, typically exceeding the energy content of the hydrogen by at least 50%. To be competitive, hydrogen would have to be produced from an energy source that is plentiful and low-cost.
• Distributing hydrogen requires new infrastructure, if it is produced centrally. Because of its tendency to make normal steel brittle, and to escape through all but the tightest seals, hydrogen pipelines would be significantly more expensive than for natural gas.
• Present methods for storing hydrogen either at high pressure or in liquefied form are very energy-intensive. Liquid hydrogen has a tendency to boil away, and the safety aspects of carrying any gas at 10,000 psi are worrying.
• Modifying internal combustion engines to run on hydrogen is an inefficient dead end. Hydrogen cars will need cheap, efficient fuel cells, or there won't be many hydrogen cars.

For China to implement hydrogen cars faster than the US, it stands to reason that they would need an edge in overcoming one or more of these obstacles. None of the above problems really plays to China's natural advantage in low-cost manufacturing. If anything, China is at a disadvantage, because it has smaller indigenous sources of energy than the US, and is rapidly growing dependent on expensive imports, to the chagrin of the whole oil-importing world. This puts them in a poor position to waste energy by converting oil and natural gas into hydrogen. And renewable electricity from wind and solar power would be in as much demand for displacing dirty coal plants, as for making clean hydrogen.

The infrastructure step is the only place I see any real possibilities, and the challenge there is that it's unclear where in the supply chain hydrogen should be produced: centrally, locally, or onboard the vehicle. Until you have that figured out, based on production technology and storage advances, you can't invest in mass infrastructure. Meanwhile, Chinese sales of cars using gasoline are growing at rates that we haven't seen here in 50 years, putting tremendous pressure on existing petroleum products infrastructure. They simply can't wait to figure out the hydrogen path, before investing to fuel today's cars.

The most intriguing possibility may actually be the one implicit in Governor Schwarzenegger's trip. If you haven't lived in California, it would be easy to miss the degree to which the state has become an important Pacific Rim country, with strong trans-Pacific trade ties and a GDP larger than that of South Korea, Thailand, Taiwan, Singapore and Hong Kong, combined. A Sino-Californian hydrogen alliance could fill most of the capability gaps I identified above, while providing two enormous early-adopter markets eager for new, clean tech. Perhaps Arnold is onto something.

Clawing Back the Windfall?

No one who watched last week's Senate hearing on the oil industry will be surprised by the latest development. On Tuesday, the Senate Finance Committee voted to incorporate what amounts to a temporary tax on oil company profits in a bill designed to provide tax breaks for hurricane reconstruction. While this may go a small way towards satisfying irate motorists, the mechanism involved will make our already stretched energy infrastructure even more vulnerable to disruption.

The proposed change would affect the way that oil companies account for the value of their inventories for tax purposes. Most companies use the Last-In/First-Out (LIFO) method of inventory accounting. Under this system, the cost of goods sold is determined by the most recent purchases, not by cheaper product already in inventory. If the Senate version of this bill passes, any oil company with more than $1 billion in sales would have to recognize 75% of the increased inventory value between year-end 2004 and year-end 2005. If that were done based on yesterday's closing price on the NY Mercantile Exchange, it would amount to about $10.00/barrel of additional taxable earnings for every barrel of inventory held by these companies. In aggregate, the Senate expects this to generate approximately $5 billion in extra taxes from the affected companies.

The arguments against this are different from those against a simple surtax on oil company profits, which would act as a general deterrent to investment in the industry. In some respects, this kind of back-door tax is even worse, because it increases the existing disincentives for holding commercial oil inventories, while taxing income that hasn't yet occurred and may never, if prices fall again. Lower inventories will increase oil market volatility and translate directly into reduced flexibility in operations.

The less inventory a refinery carries, the less it is able to respond to sudden changes in the market or events that affect crude oil supplies, such as hurricanes or terrorist incidents. Hammering oil companies for the unrealized appreciation of their inventories--not unlike taxing you for the market appreciation of your house, even if you have no plans to sell it--sends a negative and unhelpful signal to an industry that has already seen its inventories decline from the equivalent of 27 days of average refinery throughput in 1990 to only 19 days in 2004.

There could also be other, unintended consequences. LIFO accounting creates all sorts of quirks. It's entirely possible that some of the companies subject to this provision have been hanging onto inventory they might otherwise not want, to avoid realizing the earnings associated with selling it. For example, a company might have a "LIFO layer" going back to when oil was $10/barrel. Liquidating it at $60 would generate cash but also a big tax liability. However, if the Senate is going to impose that liability even if the inventory isn't sold, then the incentive to hang onto those barrels vanishes. The result of this across the whole industry might create a quantum drop in inventory.

An even more convoluted version of this scenario would entail drawing down inventories drastically at the end of December, then stocking up in early January at prevailing market prices. That would create a massive new high-cost LIFO layer, effectively trading unavoidable high taxes today for lower taxes later.

I fully understand the pressures under which our elected representatives are operating in this area. But sometimes leadership means recognizing and explaining the counter-productivity of a popular measure. The oil companies won't win any "most admired" contests these days, but it is in everyone's interest that they be allowed to function in a manner consistent with providing reliable supplies of energy, even if that means that they occasionally earn extraordinary profits when prices are high. Clawing back these profits by selectively fiddling with established accounting methods is a deeply bad idea.

Does Blogging Make a Difference?

A few months ago I mentioned signing up for TerraPass, a voluntary mechanism for offsetting automobile greenhouse gas emissions by funding projects to reduce emissions in other sectors. Now it appears that TerraPass, or more specifically their blog, may have helped defeat a ballot initiative in California. Proposition 80 would have re-regulated the market in such a way as to restrict customer choice in electric providers. Having grown up in California, and considering the market mayhem that occurred there in 2001-2, I'm somewhat surprised that this initiative didn't win, let alone that it went down to resounding defeat, by a margin of 66% against 34%. It's just possible that bloggers played a role in that defeat, as TerraPass suggests.

Why would TerraPass care about the structure of California's utility market, and why, for that matter, should anyone else? It comes down to promoting innovation and the ability of alternative energy, including "green" alternative energy, to compete in the market on an equal footing with traditional energy suppliers. If you block their access to the market--in this case to retail electricity customers--alternative energy firms won't be able to demonstrate the kind of value that attracts investors. No investors, no alternative energy. Furthermore, stifling these activities in California, where many of them have been incubated in the past, could have consequences far beyond the state's borders.

This is crucial for TerraPass and anyone else who cares about reducing greenhouse gas emissions, because alternative energy projects, including wind and solar power, are a major source of the emissions offsets on which TerraPass's business is based. They are also an important, though at this point small, source of greenhouse-gas-free energy for the economy as a whole.

I think there are a couple of takeaways from this event. First, having a market that's open to innovation appeals to a broad range of constituencies. It appears that California's voters didn't buy into the victimization model that's been foisted on them by folks peddling highly distorted versions of the lessons from the California Energy Crisis. Perhaps they understand better than their state's lawmakers that it was a poorly-designed, badly-executed deregulation that caused the problem, rather than deregulation, per se. Secondly, the non-traditional voices that are having a greater impact on politics in general turn out to be influential on energy policy issues, too. That's good news for those of use blogging away in the energy space, trying to cut through a mass of confusion and partisan propaganda.

Market Pricing

I keep seeing further reactions to last week's Senate hearing on the oil industry. While some commentators seem satisfied by explanations of hurricane-induced gasoline shortfalls and comparisons to profit margins in other industries, others continue to pursue oil company profits as if they were the next Enron scandal. While stipulating that the industry has done a dismal job of explaining how it works--not just at times of exceptional profits but throughout the boom-and-bust cycles that have typified most of its century-plus existence--I find the economic ignorance on display by journalists and elected officials simply breathtaking. In the process, the public is being misled into a conspiracy-theory mindset, hardly a tough sell in 2005 America.

For example, Friday's Washington Post business section included an article entitled, "Oil's Bigwigs Enjoy a Rigged Market." It's author, Mr. Pearlstein, offered some "simple truths", including his observation that the oil market is rigged by Middle East producers and thus doesn't justify being called a market. Perhaps he paid too much attention to Exxon Chairman Lee Raymond's muddled explanation of how oil prices are set, which should have mentioned that the Saudis and other producers do not set their prices in a vacuum, but instead pay a great deal of attention to oil markets around the world, and particularly to the futures markets in London, New York and Singapore. While it's true that the major oil companies don't set the price of the commodity, neither does OPEC, when all its members are producing flat out in a global market with essentially no spare capacity. Who sets the price, then? Buyers do, including those in Shanghai and Mumbai, by bidding it up.

Monday's Post featured an op-ed by William Raspberry, "An Oily Flavor." He correctly observed that the five industry execs couldn't adequately explain why record profits and record prices happened to coincide with the hurricane aftermath, and thus weren't the direct result of gouging consumers. (Try my posting of last Thursday for an explanation.) Where Mr. Raspberry and the CEOs went awry was in linking prices with costs. Street prices for gasoline may have gone up because suppliers raised their prices to dealers, but the prices charged by suppliers went up because a market with a voracious appetite was suddenly short about a quarter of its normal supplies, not because the cost of making gasoline had suddenly shot up. The laws of economics may not function with quite the remorseless rigor of those of physics, but in a situation like that there's only one way prices can go: up, with a vengeance. If companies had "sacrificed" by keeping prices low, as Mr. Raspberry and Senator Boxer suggested they should have, then half the gas stations in the country would have run out, and the ensuing hearings would have focused on oil company incompetence and shareholder injury, not profits.

While I could single out many other comments for similar treatment, the basic problem is that we live in a market economy in which only a small fraction of the population actually seems to understand markets or be comfortable with their adverse outcomes. And those few who do are either incapable of explaining market behavior in simple English, or are afraid that providing such an explanation would result in a populist backlash and further regulation.

If I told you that the price of oil is set in the same way as the price of a share of stock or a bushel of corn, would it make more sense than what you heard last Wednesday? Buyers buy because they have a need or think the price is going up. Sellers sell because they have more than they need or think the price is going down. Some have a bit more information about future supply or demand than others--or think they do--and some have a longer-term perspective than others. The level at which as many buyers are willing to buy as sellers are to sell is the price, for that moment. You can add as much complexity to that story as you wish, for oil, stocks or corn. You can talk about OPEC, its efforts to restrict current and future supply, and how effective it has been at different times. You can talk about the futures markets and the various forces that drive them, along with the leverage they generate when most other transactions around the world are settled based on their closing prices--something that was not true when I traded oil in the 1980s and early 90s. In other words, you can make this picture as detailed as you like, without changing its essence.

The point is that however complicated these markets are, they aren't incomprehensible, particularly to someone with a reasonable education. The failure here is not of oil markets, but of our past efforts to explain them simply and understandably. We pay for that failure every time the conversation about pricing becomes so confused and convoluted that it looks like someone is hiding something, as so many seem to have concluded from last week's panel in D.C.

Complacency and Conservation

For Americans my age and older, "energy conservation" conjures up images of President Carter appearing on TV in a sweater, as noted in this business op-ed from Sunday's New York Times. However awkward those efforts might have been, then, serious conservation behavior is appropriate again, at least for the next several months. We are in a brief, seasonal trough between two different energy crises, and it would be natural to become a bit complacent. But rather than easing up on our conservation efforts, this is just the time to put them into high gear, to avert the worst of the energy problems that winter could bring.

When the hurricanes clobbered the gulf coast this summer, they hit the refining industry as it was preparing for the end of the peak driving season and the onset of the annual transition to maximum heating oil production. In order to mitigate the resulting gasoline shortfall, refineries continued to flog gasoline production much later into the year than normal, at the expense of diesel fuel and heating oil. This is why diesel prices have fallen much less than gasoline prices have in recent weeks, and inventories of diesel and heating oil are unusually low going into winter.

In parallel with the heating oil shortfall, the hurricanes shut in about 10% of US natural gas production. 4 billion cubic feet per day of gas remains offline at this point, but inventories in storage are at about seasonal norms, due to the reduction in industrial demand resulting from high prices and hurricane damage. But that shouldn't promote over-confidence; gas inventories would have to be exceptionally high to compensate for both high winter demand and production that remains 7% below average.

All this suggests that while gasoline prices have retreated to their lowest levels since before Hurricane Katrina hit, we face an even tougher problem with heating fuels in the months ahead. And as unglamorous as it may sound, the only factor that can make a difference at this point is conservation. There's no extra production that can be brought online. There's no flood of imports waiting to save the day, as there was for gasoline. A little belt tightening now could pay big dividends when the weather gets cold.

The kind of conservation I have in mind has nothing to do with driving less, unless you own a diesel car. It's as simple as turning off unnecessary lights, waiting to run the dishwasher until it's full, and turning off the power strip--not just the pc--when you're done with it. Saving electricity saves natural gas, because 42% of the gas we use goes to generate electricity. And saving gas now frees up more to go into storage, for use in January and February.

Not only would immediate conservation ensure that there'll be more gas when we really need it, but it would also cut our gas and power bills, as part of the normal market "feedback loop." We normally focus on the other part of this cycle, in which high prices reduce demand, which in turn reduces prices, but you can jump into this loop anywhere. Voluntary conservation works just as well as the price-motivated kind, even though it's harder to explain to economists.

If you can look around your home or office without finding easy ways to save 10% of your electricity use, I'd be surprised. The aggregation of 200 million consumers doing that could bring natural gas prices down by several dollars per million BTUs, now, and shave a comparable amount off the winter peaks, later. What are you waiting for?

Optimizing Nuclear Power

Conventional wisdom is increasingly coming around to the idea that nuclear power will be an important contributor to meeting our needs for low-greenhouse-gas energy. While there are still groups that oppose nukes for both environmental and economic reasons, they are being undermined by market conditions and voices of dissent from within. When I look at the potential of nuclear power, though, I can't help wondering if we're looking at it in the right way. Are large, central nuclear power plants, with their issues of lengthy permitting, daunting project timelines, and large-scale waste management problems, the best way to use the power of the atom? An article from Technology Review suggests another approach, and I'm equally intrigued by the possibility of using nuclear to leverage conventional fuels.

The CEO of Total made news recently by suggesting that nuclear power could be the key to unlocking Canada's oil sands reserves. The more I've thought about this, the more sense it makes, as a specific and useful, non-traditional application of nuclear energy.

The basic problem with oil sands--or tar sands, as they were called before their PR makeover--is that it takes a lot of energy to free the liquids from the minerals that have trapped them, and to upgrade this heavy, sludgy material into something resembling the crude oil we pump out of the ground. The principal sources of that energy are Canadian natural gas, which would otherwise come to the US market to heat homes or produce electricity, and the solid residue from oil sands upgrading, which can be turned into synthetic gas. In either case, the combustion of these fuels generates greenhouse gases. When added to the emissions from burning the products made from the synthetic crude in our cars and homes, they make the environmental impact of the total oil sands cycle look pretty similar to mining and burning coal.

Generating the heat for oil sands extraction and processing from nuclear fission, rather than from methane combustion, would improve both the energy efficiency and climate change consequences of oil sands, putting them on a par with conventional crude oil. It would have the added benefit of removing a key constraint on the total volume of oil sands that can be recovered, which is currently restricted by natural gas availability. The net result would be to increase both Canadian oil sands production and natural gas exports.

What this really comes down to is asking what nuclear power can do better than other energy sources, and applying it there preferentially. That might not eliminate all opposition to nuclear power, but it would certainly make the benefits clear.

Vertical Integration

Yesterday's Senate hearing provided some fascinating insights, not only on the energy industry but in how our government processes work. Other than two Senators who used the occasion to attempt to embarrass the executives into supporting a specific proposal, or badger them into appearing to support something detrimental to the industry, most of the questions were thoughtful, appropriate, and stimulating--even if they didn't cover all the issues I highlighted in yesterday's posting. I'd like to focus on a question from Senator Gordon Smith of Oregon. He asked about the impact of vertical integration on high prices and industry profitability. I'm not sure he got a clear answer, or at least one that would adequately explain to the public what vertical integration in the energy industry really means today, which is quite different from what it used to mean.

When I filled up my first car at Shell stations in the mid-1970s, the gasoline I put into it almost certainly came from a Shell refinery, processing crude oil produced from Shell's oil wells and transported in a Shell tanker or pipeline. That's what we normally think of when we talk about "integrated oil companies." But however true that picture was then, it no longer reflects the way the industry actually operates. Today, while these companies still participate in the most important elements of the industry's "value chain"--the connected business segments that hand off the commodity to the next segment in line, and finally sell it to consumers--that participation is increasingly through relationships other than direct ownership of the commodity at every stage.

First, let's look at crude oil. After the wave of nationalizations in the 1970s, much of the oil previously "owned" by the international companies became the property of state enterprises such as Saudi Aramco, Petroleos de Venezuela, Pertamina, and others. The major oil companies had to rebuild their portfolios, typically on terms that involved higher royalties, taxes, and sometimes even profit caps. As production from their US oil reserves declined over the last three decades, while demand increased, most of them became increasingly reliant on third party suppliers of crude oil. Exxon, for example, produces less than half the oil they refine globally, and that doesn't factor in any production sold to third parties, due to location or quality.

The refining business has changed significantly, too. We heard a great deal yesterday about the lack of new refinery construction in the US, but little about the vast restructuring of the industry in the 1980s and 1990s, when many small refineries were shut down, and many others were sold by the majors to independents such as Valero, today's number one US refiner. This change has put most of the majors in the position of buying refined products from either independent US refiners or offshore facilities, in order to supply their domestic markets. Chevron's refineries cover only half the company's global marketing requirements.

Transportation has changed, too. Few of the companies own their own tanker fleets, and even when they do, they must supplement with chartered tankers owned by others. And while the majors still own important pipeline interests, companies such as Kinder Morgan and Berkshire Hathaway own large chunks of this critical infrastructure.

Finally, in retail marketing most of the name-brand gas stations you see are owned or operated by local businesses. Many of them don't even receive their products directly from the company, but through a distributor, who is responsible for delivery and probably maintains his own inventory.

The actual industry structure has evolved to one of "virtual integration", rather than true vertical integration, and I think this helps to explain some perplexing aspects of the current industry profitability. One of the Senators observed that it seemed odd that high crude oil prices would push up profits, when they simultaneously raise the company's cost of doing business. But when you examine this disaggregated business model, you can see how this could happen:

• High oil prices boost earnings for the Upstream, where oil is discovered and produced, on the production it owns outright, and to a lesser degree on oil for which it shares profits with foreign state oil companies.
• The refining segment pays more for its inputs, but when demand exceeds the ability to supply, refining margins go up. As a result, refining segment earnings rise, in some cases dramatically. So even for companies that experienced refinery damage or shutdowns in the aftermath of the hurricanes, the margins at their remaining facilities offset the value of lost throughput.
• Marketing sees higher costs for both third-party and company supplies--which are normally transferred at market prices--but it passes these on to dealers and distributors, and so is probably little affected.
• Retailers at the end of the chain see their costs go up, and may end up getting squeezed between their suppliers and customers. Even if they can pass along 100% of the increases, their profits may drop, since higher prices reduce the volumes they sell.

That's how a "virtually integrated" oil company can make money from each segment, even if it doesn't control 100% of its supply throughout the chain. All of these segments are run as profit centers, or as totally independent businesses, and optimize their own activities more or less without regard to the others. It's a model that has worked very well in an era of plentiful hydrocarbons and ample refining capacity. Whether it can sustain its performance in a period of scarcity and tight capacity remains to be seen.

Grilling the Chiefs

The heads of the largest US oil and gas companies, including the US subsidiary of Shell, will testify before the US Senate today (9:30 AM, C-SPAN3.) Energy markets have given the economy an E-ticket ride for the last year-and-a-half, and these conditions have produced remarkable profits at Exxon, Chevron, ConocoPhillips, etc. Under the circumstances, no one should be surprised to see energy CEOs hauled before Congress, but other than attempting to shame them for making lots of money while the rest of the country struggles to pay its fuel bills, what can we really learn?

The premise of the hearing appears to have been set by Senator Domenici, the chair of the Energy Committee, who said, “Oil companies have failed to tell us and show us what they are doing with these profits that justify them.” Fair enough, though I'm not aware of any restriction that companies may earn only those profits they can "justify"; it would certainly be news to Yahoo and Google, and to a number of large banks. The Congress could be kept pretty busy interviewing executives of companies earning more than, say, a 5% net margin on sales. (The big oils are currently making about 7-10%.)

If this is going to be more than an opportunity for Senators to show their constituencies that they are seriously concerned about our energy woes, they will need to ask more insightful questions than, "What are you doing with all the money?" Here are a few suggestions, by category:

Upstream:

• Are there any significant domestic reserves of oil and natural gas that would be economical to produce, but to which you do not have access? Where are they, and what prevents your bringing them to market?
• How can the Congress and the Government assist the industry in obtaining access to world-class energy reserves in countries that currently limit their access to monopoly state oil and gas enterprises?
• Many of your companies currently return as much cash to stockholders as you invest in finding and developing new oil and gas fields. Please explain all of the factors governing these decisions, including the influence of institutional investors and equity analysts.

Natural Gas:

• Four years ago, natural gas was touted as a cheap, plentiful and environmentally sound fuel. Why has supply failed to keep up with the growth in demand, resulting in the quadrupling of natural gas prices?
• How much natural gas is available internationally, and what investment and permits would be required in order to import an additional 5 billion cubic feet per day of gas into the US? How soon could this natural gas be available, and what impact would it have on domestic natural gas prices?

Refining & Marketing:

• Please explain to consumers how the products refined from crude oil reach local gas stations, including the use of location exchanges and "time trades", and describe your involvement in this "value chain."
• Major oil companies have sold or shut down a number of US refineries in the last 10 years. Please explain the factors involved in these decisions, and comment on the relative attractiveness of building new, "grass roots" refining capacity now.
• Several Senators and Congressmen have proposed the development of "strategic product reserves", in which gasoline and heating oil could be stockpiled for use in the event of a supply disruption or natural disaster, such as the recent hurricanes. How would these stockpiles affect existing mechanisms for meeting seasonal fluctuations in demand? What prevents the industry from holding large enough commercial inventories to meet emergency needs?

Alternative Energy:

• Please describe the economics and technological readiness of alternative energy technologies, including both unconventional hydrocarbons and renewable resources, with particular emphasis on those capable of producing liquid fuels that could be distributed through existing infrastructure.
• How much investment would be required, and how quickly could facilities be brought on-stream to produce one million barrels per day from these sources? 10 million barrels per day?

You'll note that none of these questions addresses efficiency or any other demand-side concerns. Frankly, I'm not sure the companies that supply these fuels have any deeper insights into how and why we use their products than the rest of us do, and they could spend the next month just answering the above in sufficient detail. Meanwhile, I'll be watching today with high interest--if low expectations--to hear something that might surprise me, from either side of the discussion.

Inching Towards ANWR

The pending budget legislation in Congress includes a provision allowing drilling the Arctic National Wildlife Refuge. If the bill passes with this provision intact, it should not be seen as a victory for oil companies, but rather as the failure of an unrealistically obstinate strategy by its environmental opponents. By assuming that it was possible to prevent ANWR from ever being drilled, they will have foregone any opportunity to obtain important concessions in other areas, and thus failed in the larger sense of environmental stewardship. While there might be a parallel universe in which ANWR's oil stays in the ground forever, it is certainly not the world of $60 oil in which we live.

I also question the cited 2004 study from the Energy Information Agency, suggesting that oil from ANWR would only save a penny a gallon in 2025. Anyone with experience dealing in commodity markets would find that conclusion naive. Recall that a mere delay in BP's Thunder Horse project after hurricane Dennis passed through the Gulf of Mexico sent oil markets $1/barrel higher. And Thunder Horse will produce only a quarter of the oil that ANWR is expected to yield, in terms of both peak production rate and total reserves. ANWR could comprise as much as a quarter of total US production when it starts up, if current decline rates for mature US oil fields continue. It might produce as much oil as Texas does today (onshore.)

If the world of 2025 is anything like today, with a very slim cushion between total oil demand and maximum global production capacity, that extra million barrels per day of supply from ANWR could depress oil prices by as much as $5.00/barrel, or $0.12/gallon. That's because the price for the entire global market is set by the last several million barrels per day of supply and demand, which determine whether inventories are growing or shrinking. So even though ANWR's potential production would probably only represent 1% of total global oil supply at that point, its influence as the "marginal barrel" would be greatly disproportionate.

No matter how much one believes in protecting pristine wilderness, or in the potential of alternative energy and improved energy efficiency to moderate our oil consumption in the next 20 years, it simply doesn't make sense to think that we would permanently forego the oil equivalent of another Texas on our own soil, given the current economic and geopolitical environment. Those who imagined that scenario was realistic need to reexamine their assumptions.

Cost of Carbon

One of the main points of debate in the argument over climate change concerns the cost of complying with the Kyoto Treaty or other mechanisms to reduce greenhouse gas emissions. Today's New York Times includes an editorial suggesting that the cost could be much lower than previously estimated, as low as $1.00 per ton of carbon dioxide equivalent reductions. However, the basis for this estimate is extremely weak, even though it originates in a recent study by the US Environmental Protection Agency.

Last month the EPA issued the results of their analysis of a variety of proposed clean air programs, including the Administration's Clear Skies initiative and several competing House and Senate bills. Their findings for the bill cited in the Times editorial, Senator Carper's S.843, are the source of the $1/ton estimate, although when you read the analysis, you will discover this note: "Due to modeling limitations, some provisions of the Clean Air Planning Act (Carper, S843) are not directly modeled. These provisions include the carbon offset provision." So the range of carbon credit prices reported are not apparently the result of detailed modeling. That's reassuring, because they don't even reflect the price of such offsets in today's market, let alone that of 2010, 2015, and 2020, as they purport.

For example, comparable credits currently trade in the EU at a level equivalent to about $25/ton. Prices on the Chicago Climate Exchange, which is strictly voluntary and not backed by the kind of mandatory national emissions cap envisioned in Senator Carper's bill, are already over $2/ton, and would certainly go higher if S.843 became law.

While large volumes of low-cost emissions offsets are available in the agricultural sector, the magnitude of reductions necessary over the next half-century will require industrial reductions on a larger scale, either from new energy technology that fundamentally emits less, such as fuel cells running on hydrogen from renewable sources, or by the capture and sequestration of carbon dioxide from combustion products. Neither of these methods will be cheap, compared to current power generation. Optimistic estimates of these costs are closer to $50/ton than to $1.

I'm not pointing out this discrepancy because I'm against dealing with climate change, or oppose emissions trading. In fact, I regard climate change as one of the most important issues of the 21st century, and I believe emissions trading is the only practical way in which to manage it, unless we enter a true climate crisis. However, selling this program to the American people on the basis that it would be virtually cost-free is misleading and probably counterproductive for an effort that will depend on a broad, sustained commitment over a very long haul.

Answers, Part II

Following on from Wednesday's posting, and turning to the more complicated question of our current energy problems, I'll toss out one new idea, aimed at bringing the growth in oil consumption in the transportation sector under control. While it's focused on cars, I recognize that trucking and airlines use a lot of fuel, too, and may require their own measures. Given my reticence about higher gasoline taxes, and the failure of past efforts to legislate improvements in fuel economy, I suggest we tackle the problem from a novel direction: horsepower.

When you review the evolution of cars over the last 15 years, our appetite for more power and speed has been the real villain of the piece, rather than the shift to SUVs, per se. Engine technology improved significantly during this period, but most of the potential fuel economy benefits of these advances were sacrificed in a race to boost horsepower, even for economy cars. For example, a 140 hp engine is now standard on the new Honda Civic , compared to the 67 hp powerplant of a 1980 model. Although horsepower isn't the only factor influencing fuel consumption, its importance expands when you consider indirect effects, such as enabling larger and heavier vehicles. Can you imagine a Lincoln Navigator powered by a 140 hp engine?

So why not tax excess horsepower, to encourage us to make do with less, and put downward pressure on many of the factors that have hurt fuel economy over the last 20 years? For example, we could start with a new-car tax of $1/hp for every horsepower over 100. This would apply on every car, without distinction to size, weight or class. This tax would increase by $1/hp/year, until it reached, say, $10/hp. In the case of my 270 hp Acura TL, for example, I'd pay an extra $170 if I were buying it now under this scheme, but if I bought the same new car with the same engine ten years from now, the tab would have risen to $1700. To make sure it bites properly, this tax should be collected at the time of purchase and not be financeable, so it couldn't be buried in the lease payments.

Compared to increasing our gas taxes, or imposing a tax on engine displacement, as some European countries do, this approach has the following advantages:

• It promotes efficient hybrid cars by exempting the horsepower from a hybrid's electric motors. At the same time, though, it doesn't reward "performance hybrids", which still need large gasoline engines.
• It also does not reward supercharging and turbocharging approaches that make small engines perform like big ones. That might be controversial, because turbos have been seen as being economical. They are, but only in relative terms, against the alternative of needing a bigger engine to get more power.
• It is much less regressive than fuel taxes, because it would be collected only on new car purchases, not used cars, and could be avoided entirely by purchasing appropriately economical vehicles.
• It helps offset the higher initial cost of diesel engines, which generate less horsepower for equivalent levels of performance (torque) vs. gasoline engines.

While it would clearly take years for the full fuel economy effect to be felt across the entire fleet, enacting such a tax would send a clear signal to carmakers and consumers that their priorities need to shift. I'm also aware that this tax violates my own dictum about focusing on desired outcomes, rather than on the means to them. However, it's still at least a step or two closer to that than a gas tax. It might also be more politically palatable than closing the SUV loophole in the CAFE standards, because it would preserve the critical right of consumer choice, while providing some serious incentives to move in the desired direction.

Answers, Part I

The other day one of my readers challenged me to go beyond pointing out problems and recommend some solutions. In particular, he wanted me to suggest how to reduce the threat posed by Venezuela’s President Chavez, and to identify some ways in which the US could limit its energy problems over the next five years. Tall orders, both. I'll tackle the first part of this today, and follow up on Friday.

Venezuela represents a serious problem for the US, as I suggested in Monday’s posting. Here’s a country that has historically run neck-and-neck with Saudi Arabia for second place in the list of our most important oil suppliers, after Canada. American and other western companies made large investments in Venezuela’s upstream oil sector, after the government liberalized its rules in the 1990s, and these ventures currently account for 45-50% of the country’s oil production. But in the last several years, the Venezuelan government has turned decidedly anti-American, and President Chavez’s policies and rhetoric have grown increasingly inimical to American interests in the hemisphere. Doubtless his attitude towards us wasn’t helped by our perceived complicity in the failed attempt to oust him, or by our support for his political opponents in last year's referendum on his rule. (I'm not counting Pat Robertson's recent assassination rant, here.)

Direct confrontation at this point would likely only serve to bolster Sr. Chavez’s image and appeal within his country and with the less affluent throughout South America. Instead, it seems timely to apply Zhou En Lai's clever inversion of Von Klausewitz--that diplomacy is the continuation of war by other means--and to pursue aggressive efforts to restore the flagging image of the US in Latin America. (There were some alarming statistics about these trends in this week’s Economist.)

After all, even with its fortunes buoyed by high oil prices, Venezuela's entire GDP is about the size of that of Louisiana, pre-Katrina. If President Chavez can offer his neighbors a better deal on trade and development than we can, then there’s something fundamentally wrong with the way we are looking at the problem. I’m not sure which specific measures would work best, whether a host of new bi-lateral trade deals, a generous Latin American development fund, or something else entirely, but we must surely have economic and political levers available to us that Sr. Chavez can’t hope to match.

By reducing Chavez's influence in the region, we would effectively isolate him and make him look more like the tinpot dictator that he is. That seems more fruitful than confronting him and building him up as the people's hero, who can poke his finger in the eye of the US and make us like it, because of his oil.

A Multi-Polar World

As I read this article from Sunday's New York Times on the growing environmental impact of China, I was reminded of how physicists describe the spatial distortion caused by a large mass, and the complicated interactions several large masses create between them. China is a large mass, if there ever was one, and it is joining a world currently dominated by two other large masses, the US and the EU. We haven't even begun to experience the full impact of this change, particularly when it comes to energy and the environment.

Nor is this just a function of the relative population sizes--the "China Big" effect. Rather, the development of China has been so rapid, and sufficiently distorted by state central planning, that the energy and environmental consequences of that growth have only recently become apparent against the backdrop of basic economic drivers such as employment and exports. If present trends continue, pollution from China could overwhelm the environmental efforts of all other countries. Not only is China on a path to exceed US emissions of greenhouse gases, but its emissions of "local pollutants"--the oxides of sulfur and nitrogen that have historically produced smog and acid rain in places like L.A. and the Northeast--may also have global impact. The Times suggests this is already the case for particulate pollution, as a result of burning coal without modern pollution control equipment.

This paints a very bleak picture of the decades ahead, but it's not pre-determined. All of these problems create tremendous opportunities, and that's not just a cliche in this case. The greatest leverage available for reducing future emissions is to ensure that new cars, factories, and other sources of pollution incorporate the best available technology. More of those will be added in China than anywhere else. That means if you're going to spend a dollar to reduce emissions, you can get a lot more reductions for your buck in China, than here.

I'm not suggesting letting domestic polluters off the hook. But I do think that global problems call for different approaches than we've applied to local and national problems in the past. We need to be smart about how and where we invest in reducing emissions, if we want to have the maximum impact, both on climate change and on air quality. We also need to think seriously--without fear-mongering and demagoguery--about the resulting tradeoffs between jobs, economic growth, and global pollution. Saving the environment may require building state of the art factories in China that will cost jobs here. Can our political system cope with this kind of challenge?

By the way, I'll be traveling on business for the next several days, so postings may become more erratic.

Trouble Closer to Home

While it has become fashionable to worry about the future reliability of Saudi Arabia's oil reserves (see Friday's posting) we might do well to focus our concerns a little closer to home. Venezuela supplies as much oil to the US as Saudi Arabia does, and its government is becoming increasingly hostile to American interests. As described in this article in yesterday's New York Times, the facade of the country's "Bolivarian Revolution" has slipped recently, giving way to a new take on socialism. The implications for our energy security are troubling.

Because of its proximity to the US Gulf Coast, resulting in very short transit times for oil shipments, Venezuelan crude oil has been an anchor of our post-1970s oil supply diversification. Even if only incremental Venezuelan production were lost to the US, this would be a significant blow to our supply strategy. The diversion of all our present imports from Venezuela to other countries would represent a disaster on a magnitude comparable to the recent hurricanes, with similar long recovery times, as global supply patterns rebalanced. As volatile as the Middle East may be, I find this scenario at least as credible and concerning.

As Sr. Chavez comes more and more to resemble a Castro with deep pockets, the political risk of doing business in Venezuela, particularly for American firms, increases. While the oil projects developed by international companies have become a mainstay of Venezuelan production, as the state oil firm PdVSA struggles to rebuild from the catastrophic strike of a few years ago, this privileged position has not protected these firms from threats of contract renegotiation or sudden claims for back taxes.

If the companies involved, including the entire top tier of the international oil industry, have not begun seriously to plan for the possibility of nationalization, they would be remiss in their risk management. Sr. Chavez cannot be pleased to rely on foreign capital and foreign companies for the maintenance of the engine of Venezuelan economy and of his new, expansive foreign policies. I would be surprised if, in his mind, the question were not if, but when to take control of these key assets. While Venezuela may lack the wherewithal to operate these facilities today, might other countries supply the needed expertise, until a local capability could be nurtured?

Saudi Oil Conspiracy!

My regular readers may be surprised by the tabloid-style title of today's posting. They ought to be equally surprised and dismayed by a tabloid-toned article in yesterday's New York Times, entitled "Doubts Raised on Saudi Vow for More Oil." On one level, it contains good information on the uncertainties about the size of Saudi Arabia's oil reserves and the prospect for substantial production increases in the Kingdom. What I find alarming is its approach to this information, with references to a "secret intelligence report" and comments from "a senior intelligence official, who insisted on remaining anonymous," as if questions about Saudi Arabia's oil reserves were in the same category as those about Iraq's WMD.

Contrary to the view you might reasonably form after reading the Times article, the debate about Saudi Arabia's reserves and production capabilities has been quite public. It includes a bestselling book by Matthew Simmons, "Twilight in the Desert," on which I've commented extensively. It has also included detailed presentations by various Saudi Aramco officials, who substantially increased their disclosure of technical information and production plans, even if this still fell short of what you'd get from a publicly traded oil company or a state oil company such as Norway's Statoil. In my view, the Kingdom's own long-term interests--and ours--require greater transparency on their part, as well as a willingness to allow access for foreign companies and foreign capital. However, that doesn't make the situation a scandal.

It's also worth noting that while Saudi Arabia has been the world's largest oil supplier over the last couple of decades, Russia currently produces about the same quantity of oil, and new volumes are coming on line from a number of other countries, many of them outside the Middle East. Nor would ramping up Saudi Arabia's oil production necessarily provide instant cheap-gasoline Nirvana here, because global capacity to refine the heavy, high-sulfur crude that constitutes most of Saudi Arabia's incremental capacity is limited and will not expand until new refineries are built and existing plants upgraded all over the world.

Whatever the realities behind Saudi Arabia's reticence to disclose more information about its oil industry, portraying the situation as yet another US intelligence failure borders on the irresponsible. If we are casting about to assess blame for our dependence on reclusive Middle Eastern kingdoms, we need to start with the fact that we now consume 1/3 more oil than at the end of the last energy crisis, while producing 1/3 less oil here in the US.

Storm Signals

2005 has been an extraordinary year for natural disasters and unusual weather, and there are still two months remaining. People of many persuasions are looking at these events for signs, whether of millenarian portents or signposts of the accelerating impact of human activities on the earth's climate. We've already set a new record for the number of named Atlantic basin cyclonic storms, following a year that was no slouch, either. Are all these hurricanes telling us something about the climate, or are they just bad weather?

Several months ago, I cited a scientific paper correlating warmer ocean temperatures with more intense hurricanes, suggesting that further climate change will deliver more hurricane seasons like the one that's now nearing its official end. Nevertheless, the author of that paper is adamant that Katrina and Rita should not be claimed as evidence in support of climate change. If you find that distinction confusing, you aren't alone.

Part of the difficulty in filtering out the noise from any signal here lies in the distinction between climate and weather. Weather is what we experience day to day and year to year, while climate is a long-term picture at the local, regional, or global level, over time spans that are long relative to human perception. "Climate change" isn't just a bureaucratic euphemism for global warming; it's an accurate description of the territory that scientists must examine when they look for evidence of global warming. A single year's weather, however bizarre, may or may not represent a statistically significant departure from the previous norm.

The other problem is a human one. Because we're only alive for "threescore and ten", give or take, there's a natural tendency to assign extra significance to events that occur during our lifetimes. Hurricane Katrina affected people we know, or at least could see on TV, while the comparably destructive hurricane of 1900 is now just a historical footnote, even though it permanently altered the course of development of east Texas. (Without it, "Galveston", not "Houston" might have been the first word spoken from the Moon.)

I have to agree with Dr. Emanuel that it's probably premature to assign extra significance to the hurricanes of the last two years. At the same time, though, these storms--along with recent pictures of a summertime ice-free path around the north pole--provide worrying glimpses of a future in which climate change could alter the planet in ways that we may not find conducive to "life, liberty, and the pursuit of happiness." So while they may not serve as evidence, these hurricanes are still important signposts.

Future Cars 2005

I love car shows. That's partly because I fell in love with cars as a teenager, but also because car shows give you more hints than you'll get anywhere else about the models that might be in showrooms in a few years. That has become a much more interesting question than it used to be, as automobile powerplants have morphed to run on different fuels, or hybrids of gas and electricity, and in some cased to eschew internal combustion altogether. Even though most of the cars at auto shows are simply early versions of next year's models, or experiments in letting styling departments run wild, every now and again you get to see something truly novel and future-changing. This year's Tokyo Motor Show has at least one car that might fit the latter category.

While it's fun to see rakish new designs, and encouraging to see a true sports car that would get 70 miles per gallon (of diesel), it's truly cool to glimpse a car that fundamentally redefines what automobiles can do. Look at the Nissan Pivo. Not only is it all-electric, running on Lithium-ion batteries like your laptop, but the passenger compartment can swivel through 360 degrees of motion, altering entirely the dynamics of parking or "backing out" of a space. Other nice touches include drive-by-wire and tv screens on the pillars, linked to tiny external cameras, eliminating those pesky blind spots that complicate passing.

I concede that we may never see a Pivo in a showroom. It will likely go the way of the four-wheel-steering feature that a couple of manufacturers tried to introduce a few years ago. But it exemplifies what I have in mind when I suggest that a real breakthrough in performance--by which I mean the vehicle attributes on which consumers place a premium--could throw our glacial estimates of the rate of market penetration for hybrids and fuel cell cars into a cocked hat. Give people something truly new, exciting and useful, and they might line up in droves to trade in their old cars at a clip matching the turnover rates of the 1950s and 1960s, when people bought new cars every 2 or 3 years, instead of every 6 or 7. That would have major implications for our future energy consumption.

A Balanced Tax?

As gas prices retreat from the highs triggered by the two hurricanes, I expect to hear more suggestions along the lines of yesterday's New York Times editorial. It proposed a new gasoline tax that would keep prices at close to current levels, even after the underlying commodity price drops sufficiently to return gas to $2 or less, whenever that might be. While I give the Times credit for recognizing the regressive nature of gas taxes, even at the modest current level of 18 cents per gallon (Federal,) their reasoning includes two very shaky bits of economics, as well as a practical impediment that appears insurmountable, today.

First, consider the potential for this kind of tax to distort the economy. You can't tax gasoline without taxing diesel fuel, unless you want to promote a dramatic shift towards diesel cars, such as Europe is experiencing. And once you tax diesel, affecting short- and long-haul trucking costs, you're tweaking the entire supply chain for just about everything used in our homes, offices and factories. However, unless you were to tax jet fuel at a comparable level--thereby kicking the nearly-dead dog of US airlines even harder--you will also induce some odd shifts from trucking to air freight, and stretch our creaky passenger air transport system even further.

Ultimately, it makes little sense to tax one kind of energy and not all kinds, in proportion to their import sensitivity, impact on the environment, or some other consistent, logical basis. That, by the way, is precisely what a carbon tax does, and it would make more sense than a simple gas tax, though there are even better alternatives available, including emissions trading systems.

The Times also asserts that gas taxes create incentives for companies to invest in alternative energy. In fact, the opposite is true, because a high gas tax would reduce gasoline demand, putting downward pressure on its wholesale (pre-tax) price, and thereby on the price of crude oil. Thus, higher gas taxes would drive crude oil prices lower, reducing the attractiveness of any form of alternative energy that competes with oil on any level.

The final implausibility is that a tax like this could be approved without a revolutionary change in US politics. Despite growing concern among conservative members of Congress about energy security and the connection between energy and the War on Terror, it's hard to imagine the present Congress or administration passing a brand new tax. On a more basic level, the American public doesn't like expensive gasoline. One would have to be truly oblivious to have missed the vivid display of that dislike over the last several months. Our complex energy problems are not amenable to simple solutions, particularly ones lacking a wide base of public support.

Looking East

BP made news recently with a set of announcements concerning some big investments in India and China. They will apparently invest several billion dollars building a new refinery in India and refining and marketing assets in China, both in conjunction with large local partners. While this seems to answer those who have criticized the major oil companies for reinvesting too little in the business and returning too much of their profits to shareholders, the profit mechanisms for these new ventures are by no means certain, if past experience in the region is any indication.

Most of the large oil companies began to look for opportunities in China and India in the early 1990s, after a decade of highly profitable growth in the smaller, but rapidly growing countries of Asia, including Thailand, Malaysia, Singapore, and the Philippines. Exxon and Shell were early leaders in this race, forging substantial relationships with large state companies such as Sinopec and the Indian Oil Company (IOC). Turning these beachheads into thriving businesses has proved harder, however, and a decade has passed with only gradual evolution in the areas most critical for the creation of profitable, free-market based businesses. A handful of local companies still enjoy quasi-monopolies, and governance and partner relations still cause serious concern among investors.

Clearly, both of these countries will need significant foreign investment to develop their petroleum sectors to support both economic growth and increasing mobility. But it would be a mistake to assume that means they will develop along Western lines, or in ways that will contribute meaningfully to the bottom line of those companies investing there. This is particularly true in China, where the oil sector is still viewed as a "pillar industry."

In effect, the majors are in a quandary. They must reinvest the tremendous cash flows they are throwing off currently, or else risk being marginalized in the decade ahead by the state oil companies that control most of the world's oil and gas reserves. As many analysts have observed, the best upstream oil opportunities are off-limits, locked up either by resource nationalism or environmental restrictions. The majors also need to show the markets that they can extend their record of profitable growth, in order to keep share prices advancing and thus total return to shareholders high, and where better to do this than the most populous, fastest growing countries on earth?

But having operated in this area for so long, they can't be under any illusions about the risks they are taking on, and that one of the likeliest outcomes is a wave of new refinery construction that will alleviate current global tightness in refining capacity, destroying refining margins in the process and undermining the profitability of the entire global downstream sector. That might sound good from a consumer perspective, but it could leave the big oil companies strapped for cash at just the point they'd need to be spending big money bringing alternative energy projects on line, if conventional oil supplies can't keep up with demand.

Are We Ready?

For more than 20 years, it's been nearly an article of faith that no new nuclear power plant would be built in this country. Last year, a consortium of US power generators banded together as NuStart, to resurrect the US nuclear power industry from its post-Three Mile Island, post-Chernobyl purgatory. The group recently announced the selection of two sites for which to pursue approvals for constructing a new reactor, one in Alabama and the other in Mississippi. Whether these plants will actually be built depends on a lot more than the incentives and protections included in the Energy Policy Act of 2005. Has the cumulative impact of the Northeast Blackout of 2003, high energy prices, and the two hurricanes changed the socio-political landscape sufficiently for this to be more than a pipe dream?

Clearly, the justification for nuclear power has been altered by circumstances and events. Importantly, there's a real case to be made for nuclear as a response to climate change, including its possible use to generate hydrogen for fuel cell cars. Looking beyond the US, a couple dozen new plants are either under construction or in prospect around the world. Step back from the logic, though, and you have to wonder why Entergy and its NuStart partners think that the US public's mood has changed enough to give nuclear its second wind. Favorable poll results might help, though other recent polls suggest nuclear is still less popular than other energy options. When you consider the experience of other energy mega-projects, it's hard not to be skeptical.

Now, a nuclear power plant and a Liquefied Natural Gas terminal are different propositions in almost every way, except for the issue of perceived risk. If anything, our need for imported natural gas is more critical than for the CO2-free electricity nuclear plants generate. Gas prices have quadrupled, entire domestic industries are being offshored due to a lack of affordable gas, and we face a winter that might just see gas curtailed--cut off--for some commercial and industrial users. And yet, where is the groundswell of support for LNG? It's entirely possible that Congress and the Federal Energy Regulatory Commission will end up having to cram LNG down the throats of some coastal towns, for the good of the nation. That won't be pretty, but can you imagine the politics of that if the facilities involved were nuclear power plants, instead of ports for bringing in our cleanest, fastest-growing fuel?

So even though I believe nuclear power should be part of our energy mix for the foreseeable future, I'll be a lot less skeptical on the day when the leaders of the communities that have been fighting LNG tooth and nail stand up and say, "We really don't like this stuff, because a whole lot of folks have scared us about its dangers, but we know we need it to keep our houses warm, our employers competitive, and the country strong. Go ahead and build your LNG terminal."

Tackling Demand

With the US energy industry beginning what promises to be a long recovery from the Katrina/Rita double-whammy, it's worth reminding ourselves that, although supply problems have been a persistent feature of the oil market for the last couple years, it's largely the growth in demand that has landed us with $60 oil and a stretched global refining system. As Daniel Yergin of Cambridge Energy Research Associates has pointed out in recent op-eds, the current energy crisis is primarily a demand shock, not a supply shock such as we experienced in the 1970s. So while it's to important to address our overall supply of energy, the demand side of the equation is equally crucial.

There are lots of ways to reduce demand, most having to do with improving efficiency, but an increasing number of advocates are focusing on gasoline taxes. As I discovered last May, the decline in fuel economy attributable to the popularity of SUVs only explains part of the growth in US gasoline consumption. The steady increase in annual vehicle miles driven contributes significantly, as well. Shifting the way we use our cars turns out to be just as important as the kind of cars we drive, and the current diplomatic flap over the non-payment of the "congestion tax" by US embassy employees in London highlights a more focused alternative to higher gas taxes.

Many European cities have been plagued by terrible traffic for years. When I lived in London in the early 90s, a 10 mile commute could take 90 minutes, and things have gotten worse since then. Several cities in the EU have introduced congestion taxes, with drivers paying an extra charge for entering the downtown. Though hardly popular, these fees have helped improved traffic conditions in the City of London (the "square mile") and elsewhere. And while not primarily intended to reduce fuel consumption, congestion charges generate fuel savings not just for those who switch to mass transit, but also for those who spend less time stuck in gridlock. New technology may help with this, as well.

Before we hike the gasoline tax in this country (even if it's to fund Social Security private accounts, as recently proposed in the NY Times,) I'd like to know we've given more targeted measures such as tolls and congestion fees a fair try. This kind of approach also provides a useful perspective, in which our current fuel problems are revealed as only one aspect of the larger problem of overburdened infrastructure.

Energy Policy vs. Energy Plans

Some interesting comments on yesterday's posting got me thinking about what optimism and pessimism mean in the context of increasing the contribution of renewables and other alternative energy in a reasonable amount of time. More to the point, what kind of energy mix could we expect to fall back on, if we should find ourselves missing a significant chunk of our oil imports, either as a result of a geopolitical event, or due to the impact of depletion on global supply?

Answering that question requires wading through a host of big uncertainties, and it really calls for a scenario approach, rather than straight-line reasoning. That's more than I can take on in one day's posting, but I feel safe suggesting that we will need a much more aggressive energy plan than the one implicit in the current forecasts from the Energy Information Agency of the Department of Energy. Their 2005-25 reference case would have us using 1/3 more oil by 2025, while importing 60% more of it. At the same time, they don't see the energy contribution of renewables growing by enough even to cover what will be lost in the decline of domestic oil production, or to prevent renewable energy falling as a share of total consumption by 2025. This is not a slam on the DOE, because that's probably a reasonable status quo forecast. However, it doesn't constitute an acceptable national plan for energy. I'd also argue that it's out of synch with worldwide trends driven by climate change and two globalizing "billionaires."

If the DOE's view represents a floor for alternative energy, where is the ceiling? While there might not be any laws of physics preventing wind and solar power from ultimately providing most of our energy, several issues will limit their contribution over the next 20 years. The cost of energy storage is a big factor in this calculation, and we must assess how long it would take a breakthrough in this area to go from laboratory to low-cost, mass production. I'm not an expert on technology development cycles, but 10-15 years doesn't sound too long. If that's the case, then even with a continuation of the steady cost reduction trends for both wind and solar, their intermittent nature will impede their penetratation of the power market. Nor does that address our need for non-oil transportation fuels, which by 2025 might include a modest component of hydrogen. Despite this "pessimism", I expect both wind and solar to grow dramatically in the next decade, with results that should be noticeable at the scale of our national energy statistics.

The divergence betweeen the status quo future and what's realistically possible highlights an important distinction between the Energy Policy Act of 2005 and a true national energy plan. Plans include goals, as well as the means for achieving them. What we need are explicit, quantified national goals, and these would have to include things like the following:

• To reduce our use of oil as a fraction of the total energy we consume, e.g. from 40% down to 35% by 2025.
• To increase the contribution of non-hydroelectric renewable energy from less than 1% today to 5% by 2015 and 15% by 2025.
• To shift our energy imports from being 85% oil-based to 50% gas-based, including LNG and synthetic liquid fuels produced from gas.

Now, these still might not seem like aggressive goals to a real optimist, but achieving them in the real world would be an enormous stretch, even with ample R&D funding, government incentives, and an increase in the gasoline tax. Whether or not we'd hit these targets on time, this is what it would take for "alternatives to be in place," as I suggested yesterday. I'm also reminded of the portion of JFK's quote about going to the moon that we rarely include,

"...and do the other things, not because they are easy, but because they are hard, because that goal will serve to organize and measure the best of our energies and skills, because that challenge is one that we are willing to accept, one we are unwilling to postpone, and one which we intend to win, and the others, too."

The Contrarian View

One of the consultants I used to work with liked to remind workshop attendees of a psychological phenomenon called "availability bias." As he described it, this explained the difficulty most of us face in trying to imagine a world much different from the one we observe today. When the price of oil had dropped into single digits in the late 1990s, few industry leaders could envision it returning to $25/barrel, even though it had been there only eighteen months previously. Now, with oil at $60+, who sees it reverting to $25? Apparently, at least a few people do, and here's a good example, from a blog that takes a view diametrically opposed to the adherents of Peak Oil and other scarcity scenarios.

The argument it makes is sound economics: higher prices should spur innovation and more production, while dampening demand, thus eventually restoring prices to pre-crisis levels. This proposition has history on its side, as the author notes. Things might just turn out that way again this time. However, I think it's important to understand why this argument won't always be true, because of a close relative of our old friend, compound interest. The demand for oil grows the same way that interest compounds in a passbook savings account. The rate of growth may change from year to year, but each year it is applied to the entire previous year's quantity, which includes an increment over the year before, and so on.

That's how oil demand grew from 63 million barrels per day (MBD) in 1980 to 84 MBD today. If consumption continued to grow at 2% per year, then we'd be at 93 MBD in 2010, 113 in 2020, and 138 MBD in 2030. Considering the potential of China and India, it's not hard to imagine this kind of growth for the next 25 years, at least in the abstract. But the result, compared with holding demand steady at current levels, would be incremental consumption over this period of 235 billion barrels. In effect, we'd burn an extra Saudi Arabia. By 2050, growth alone would have consumed almost a trillion additional barrels, which is roughly equal to current global proved oil reserves.

As long the quantity of recoverable oil in the earth's crust is finite, whether it's one trillion barrels or 17 trillion, we can't play this compound growth game forever. At some point, higher prices won't yield more oil, anywhere. If we don't have our alternatives in place at that point--not on the drawing board, but tested, built and ready to go--the dislocations are going to be severe. The only question left is when this will happen, and the reality is that no one can tell you until we are there, not M. King Hubbert, not Matt Simmons, and certainly not me.

Two Double-A Cells at a Time

I received several comments on last week's post relating to energy density, mostly disputing my suggestion that low-density sources such as wind and solar could ever cover more than a fifth or so of our energy needs. That's really an argument for another day, though. The focus now, particularly for solar power, should be on how to provide 2% of our primary energy supply, not 10 times that. Company strategists should still be looking for applications that are less price sensitive, not trying to penetrate the mainstream market with a technology that's not ready. This article from Technology Review gives some useful hints.

When you evaluate the hierarchy of energy costs, grid-based power--even at the retail end--is pretty low, at least on average. Backup power is more expensive, but with an iron focus on high reliability, that's hardly the place for intermittent energy sources to attack. Battery power is further up the pyramid, and disposable batteries are close to the top, in terms of cost per kilowatt-hour of electricity delivered. Flexible solar cells, such as the ones described in the article, could be incorporated in device design in such a way as to reduce the required capacity of rechargeable batteries or eliminate disposable batteries entirely in some applications. In fact, the cost of solar is not the obstacle here, as it is in the residential market, since it is already at or below the cost of power from disposable batteries. The real issue is incorporating it into devices in a seamless way, without adding too much bulk or funky attachments.

If you want a picture of how alternative energy is likely to develop, don't watch the heart of the market, where petroleum products and large, central power plants have had a century to hone their competitiveness. Watch the margins, and watch trendsetters. A solar iPod, anyone?

Petroleum Bomb

I'm at a conference, so today's posting will be brief. Former Secretary of State George Schultz and former CIA Director James Woolsey have put out a clearly-articulated op-ed on the need to reduce our dependence on oil from the Middle East. It's worth reading, particularly since it anchors one end of the Geo-Green alliance that I've mentioned in a number of previous postings. Unfortunately, the crucial element missing from this article is the time required for the strategies these gentlemen propose to have a meaningful impact on world oil markets. There are no quick fixes to these problems.

Relying on the penetration of efficient cars into the vehicle fleet, and the development of new technology for producing biofuels more efficiently than crop-based processes can deliver, the proposed transition would take more than a decade to put a real dent in our oil demand, particularly if it did not include measures to reverse the existing trend in increasing vehicle miles driven. Europe's shift to diesel, discussed here last week, provides a baseline for comparison; it took more than a decade for diesel cars to reach 50% of new car sales, and with the slow fleet turnover rate, it will be some time before they account for half of all cars in the EU.

I am not saying that Messrs. Shultz and Woolsey's idea shouldn't be tried, but in practice this strategy would not achieve its desired geopolitical impact until well into the next decade or beyond.

The Hurricane Scenario

A train ride to D.C. provided an opportunity to catch up on my large backlog of articles, including this one from the New York Times (which alas is now in their paid archives) on the impact of hurricanes on offshore oil production in the Gulf of Mexico. As it happens, the article was written a few weeks before Katrina and Rita swept through the oil patch. The hurricane damage it described was from last year’s Ivan, which caused disruption to oil and gas operations that had not been entirely repaired a year later, but the comments apply to the current storms, as well. After several months, it’s possible to consider the long-term effects of all these storms, including the influence of what I’d call “the hurricane scenario” on future global oil production.

Once a hydrocarbon reservoir has been discovered and its size estimated, the economics of producing the oil or gas it contains must be carefully evaluated. This process has become much more sophisticated over the years, incorporating market and expert assessments of future energy prices and all the risks that could affect a project's economic viability. This kind of detailed analysis is crucial when a billion dollars or more of investment and many hundreds of millions of Net Present Value are at stake.

The Gulf Coast hurricanes of 2004 and 2005, and the prospect of a pattern of such storms for years to come, will explicitly shift the risk assessment for the large platforms required to exploit oil and gas in the deep waters of the Gulf. Developers will have to consider scenarios in which each platform would experience a Class 4 or 5 hurricane every couple of years for the next 10-20 years. This will change the economics of oil platforms in important ways, by increasing the cost and complexity of these projects, as well as elevating the risk of substantial delays in project startup--one of the top influences on project NPV.

Now, this all sounds pretty esoteric, and you might think it’s only important from the perspective of higher insurance rates for oil companies. But it would also shift the economic breakeven point of deepwater oil and gas projects toward the larger end of the size distribution of fields. In other words, some fields that today are just big enough to support development under last year’s criteria would become too small to be economical, even at high energy prices. That would truncate the long-term production potential of the deepwater Gulf, which is the most promising and prolific area in the US oil & gas industry and may contain up to 70 billion barrels of oil equivalent. That means lower future US oil production, higher imports, and more pressure for both conservation and the exploitation of non-conventional resources (see yesterday’s posting.) Not good news for energy consumers.

It’s going to take months to sort out all of the impacts of these storms. In the hierarchy of consequences, the fallout I’ve described above will probably be much less noticeable than the cost of heating our homes this winter. Despite this, it will subtly reshape our options for solving our energy and environmental challenges, in ways we can't predict today.

Where the Lunch Bill Gets Paid

One of the repeated themes of this blog is the tradeoffs inherent in our decisions about energy consumption and supply policies--tradeoffs we have all too often ignored, until events such as the recent hurricanes bring these truths home. The global energy system is extraordinarily complex, with direct and indirect inter-connections that are often subtle enough to elude the most experienced analysts. Another article from Sunday's New York Times nicely illustrates the "no free lunch" aspect of these connections, in this case with regard to the environmental impact of oil sands production in Canada.

In the years ahead, resources such as these unconventional oil deposits in northern Alberta Province will become increasingly important in meeting North American and global oil demand. It's worth spending a few moments considering how oil sands recovery, which had previously been regarded as a marginal or uneconomical proposition, moved up the ladder of the energy industry's corporate capital allocation processes. This story has deep connections in US environmental and land use policy, in energy efficiency policy, and in the personal responsibility of individual consumers of energy.

When you look at where oil companies are currently producing oil, and where they expect to produce it in the future, some trends are clear. There has been a marked shift away from drilling in the US--other than the deepwater Gulf of Mexico--and toward opening up "frontier" areas such as the Caspian Sea region and parts of West Africa. At the same time, companies have had to go after more technically challenging opportunities such as deposits in ever deeper ocean depths, and oils that require significant processing and upgrading before they can be marketed. These include Venezuela's Orinoco Belt and Canada's oil sands, a.k.a. "tar sands."

Much of this shift would have happened in any case, because some of these opportunities were highly attractive, but part of the shift has occurred because domestic opportunities with lower technical and political risks (at least in the sense that one thinks of that term in the developing world) were foreclosed. I believe it is valid to draw a direct linkage between our decision to sequester vast oil and gas resources in Alaska and the offshore lower-48 and the increased attractiveness of mining oil sands in Canada, with everything that entails for the environment there. We have, in fact, made a value judgment trading the Canadian wilderness for our own, and for our coastal viewscapes and property values.

At the same time, consumer preferences for larger vehicles--facilitated by the well-known "SUV Loophole" in the federal Corporate Average Fuel Economy standards--have increased global demand for oil at a higher rate than would have otherwise been the case, accelerating the industry's push into the frontiers described above. Again, we've made an implicit tradeoff between our own personal consumption habits and the environmental and developmental impacts of drilling in more remote, less developed places.

All of these tradeoffs might be defensible, but they've been made blindly, without the debate that should have accompanied them. My purpose in bringing this up isn't to assess blame. Rather, as we consider the legislation that is bound to come up as a result of high energy prices and the deficiencies highlighted by the recent hurricanes, these tradeoffs should be explicitly considered. If we choose to continue the offshore drilling bans in Florida, California and elsewhere without taking concrete steps to reduce demand--by an amount proportional to the production these areas could contribute--then we must ask from where the difference will be made up. Alaska? Saudi Arabia? The North Pole? Or will we just continue to shrug our shoulders and assume that the fuel we need will materialize from somewhere far away, out of sight and out of mind?

This isn't just about responsibility, either. If you believe, as I do, that we are at the beginning of a lengthy transition to an energy world that is much less dependent on fossil fuels, then there are real decisions to be made about which areas should and should not be drilled--ever. But those choices need to made in a way that recognizes the vast quantities of hydrocarbons that will be consumed before we reach that destination, and our own role in determining the magnitude of that demand.